Hedge effectiveness requirements

Rebalancing is permitted for the purpose of maintaining the hedge ratio to comply with the hedge effectiveness requirements. Changes to designate quantities of a hedged item or hedging instrument for a different purpose do not constitute rebalancing.

Continuation of hedging relationship

Rebalancing is accounted for as continuation of the hedge relationship.

In other words, when rebalancing occurs, the existing hedge accounting is not discontinued, but instead the hedge ineffectiveness of the hedging relationship is determined and recognised immediately before adjusting the hedging relationship.

When the hedge ratio is adjusted, the changes in the hedging relationship between the hedging instrument and the hedged item arising from the underlying or other risk variables are taken care of by the entity. In other words, rebalancing allows the continuation of a hedging relationship whether the hedging instrument and the hedged item changes in a way that can be compensated for by adjusting the hedged ratio.

Rebalancing should not create hedge ineffectiveness

Sometimes it may so happen that the changes in the fair value of the hedged instrument and the fair value of the hedged item cannot be synchronised by adjusting the hedge ratio. An entity analysis the source of the hedge effectiveness that is expected to occur during the tenure of hedging relationship and should examine whether the changes in the extent of offset are:

  1. fluctuations around the hedging ratio continues to appropriately reflect the relationship between the hedging instrument and the hedged item; or
  2. an indication that the hedge ratio no longer appropriately reflects such hedging relationship. The entity should ensure that the hedging relationship does not reflect an imbalance between the weightage of the hedged item and the hedging instrument so as to create hedge ineffectiveness.

Fluctuations not requiring rebalancing

Certain fluctuations around a constant hedge ratio resulting in hedge ineffectiveness cannot be reduced by adjusting the hedge ratio in response to each and every outcome. In such situations, the entity should evaluate the hedge ineffectiveness to be treated appropriately. In such a situation, rebalancing may not be required.

Fluctuations requiring rebalancing

If the current hedge ratio results in increasing hedge ineffectiveness and if after proper evaluation it is observed that the hedge ineffectiveness can be reduced by adjusting the hedge ratio, then the entity should consider adjusting the hedge ratio. But rebalancing the hedge ineffectiveness of the hedging relationship should be determined and recognised immediately before adjusting the hedging relationship.

Rebalancing hedging relationship and changes to hedge ratio

As mentioned earlier rebalancing refers to the adjustments made to the designated quantities of the hedged item or the hedging instrument of an already existing hedging relationship for the purpose of maintaining a hedge ratio that complies with the hedge effectiveness requirements. Changes to designated quantities of a hedged item or of a hedging instrument for a different purpose do not constitute rebalancing for the purpose of this Standard.

Hedges of a net investment in a foreign operation

As per Ind AS 21, net investment in any foreign operation is the amount of the reporting entity’s interest in the net asset of that operation. Such foreign operations may be subsidiaries, associates, joint ventures or branches. Ind AS 21 requires an entity to determine the functional currency of each of its foreign operations as the currency of the primary economic environment of that operation. When translating the results and financial position of a foreign operation into a presentation currency, the entity is required to recognise foreign exchange differences in other comprehensive income until the foreign operation is disposed off.
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Accounting for net investment hedge – Only functional currency

Hedge accounting is applicable only to the foreign exchange differences arising between the functional currency of the foreign operation and the parent entity’s functional currency. It is not applicable for translation differences arising on account of presentation currency.
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Illustration of a net investment hedge by a parent entity

Entity A is the Parent having INR as its functional currency. Subsidiary B has Euro as its functional currency. Subsidiary C has GBP as its functional currency and the functional currency of Subsidiary D is USD. Subsidiary B has ECB amounting to $ 50 million. The following diagram best illustrates the hierarchy with corresponding investments in the subsidiary entities.
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Steps in a cash flow hedge

Identify the hedged item Identify the hedging instrument Designation/qualifying criteria of the hedge Hedge effectiveness requirements to be fulfilled Account for the hedging relationship Rebalancing and discontinuance of hedge accounting
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What is a fair value hedge?

Fair value hedging as the name implies strives to hedge the fair value of an existing asset or liability and certain other firm commitments. In a fair value hedge, the fair value changes to the hedging instrument and the hedged item are recognised in profit and loss account.
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Steps involved in fair value hedge accounting

Identify the hedged item Identify the hedging instrument Designation/qualifying criteria of the hedge Hedge effectiveness requirements to be fulfilled Account for the hedging relationship Rebalancing and discontinuance of hedge accounting
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Accounting for fair value hedge

The hedge should be designated at the inception of the hedging relationship and a formal designation and documentation of the same required. The documentation should contain the entity’s risk management strategy and objective for undertaking the hedge. The effect of the credit risk involved in the hedging instrument, viz, the counterparty credit risk should not be such that it would vitiate the fair value changes of the hedging instrument.
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Accounting for the forward element

Change in the fair value of the forward element of a forward contract that hedges a transaction related hedged item should be recognised in other comprehensive income to the extent it relates to the hedged item. The cumulative change in the fair value arising from the forward element of the forward contract shall be accounted for as follows:
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Treatment of time value /forward points in derivatives

An entity is allowed to designate only the change in the intrinsic value of an option contract in a hedging instrument. Similarly an entity can also designate only the change in the spot value of a forward contract in a hedging instrument. In such cases, the time value of the option/forward points is accounted for depending upon the type of the hedged item that the option/forward contract hedges. The option/forward contract could be to either to hedge a transaction-related hedged item or a time-period-related hedged item.
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Accounting for the time value of options

The time value of options contract may be separated from the fair value of options contracts and the entity can designate only the change in the intrinsic value of the option. If the entity chooses to do so, then the time value of the option contract is dealt with in the following manner:
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